De-leveraging, What it is and What it Means

De-leveraging is the process by which consumers are paying down their debt (mortgages, home equity lines of credit, auto loans, and credit cards) or having it written off by lenders or discharged in bankruptcy. Consumers have taken thirty or more years to get into the position in which they owe too much in relation to what they own and they will not get out of this position quickly.

There will be at least three results of consumer de-leveraging. Two are baked in the cake. The third is a result of government actions taken so far and it could be changed.

1. Lower Consumer Spending

When consumers pay down loans and increase savings, they will spend less. Consumer spending has recently made up about 70% of GDP, but this was not always the case. In the past, consumer spending was generally 60% to 65% of GDP and that is the direction we are likely to move again. That means fewer $4.00 cups of coffee and fewer $40,000 new cars.

2. Lower Corporate Earnings

Most of corporate America depends, directly or indirectly, on consumer spending so a reduction in consumer spending will also mean lower or slower growing corporate earnings. That means slower growth in the stock market and lower returns in the 401(k) plans that millions of Americans will be depending on for their retirement.

3. Slower Growth in the U.S Economy

To understand why this is optional and not mandatory, we need to understand why consumers borrowed too much and that there is another way out of the financial mess. First, economic slowdowns are as normal for the economy as breathing is for you and I. Inhale – growth; exhale – contraction and liquidation of bad investments. This cycle has been going on for hundreds of years in the U.S.

However, politicians in their ever present desire to keep getting re-elected, figured that if they could eliminate the pain (unemployment and bankruptcies) associated with recessions, they could stay in office forever. So, among other things, they created the Federal Reserve System and gave it, as one of it’s tasks, maintaining full employment.

The Fed, dutifully cuts interest rates every time there is an economic slowdown. Instead of poor investment decisions being revealed for what they are, more money is borrowed and more bad decisions are made. Problems that should be corrected through liquidation and bankruptcy are simply compounded into ever larger problems and ever greater debt. That is how we got into an unsustainable housing price bubble.

Right now the Fed (and the Treasury, Congress, and the Administration) are hoping that near-zero interest rates and massive government spending and bailouts will get the economy going again. Considering that we got into this problem with too much borrowing, what are the chances that even more borrowing will get us out of it? Ask the next former alcoholic you meet that question.

Low interest rates helped to get us into this mess and only higher interest rates will lead to the savings that we need to get out of it. Low interest rates and high government borrowing crowd out private investment and that will result in slower growth in the U.S. economy, a lower standard of living for Americans, and a self-perpetuating cycle of government deficits that must be fed with massive borrowing.

We have been down this road before. Think Jimmy Carter. We got out of that fix by shrinking the size of government (barely) and lowering tax rates. Deficits rose in the short-term but the rapid economic growth incentivized by lower taxes and decreased regulation produced a doubling of tax revenue in only a few years.

While we could go that way again, all indications are that we are re-playing the Hoover/FDR policy prescriptions of the 1930’s that will increase the size, scope, and cost of government and that will prolong and deepen the recession. Their policies helped turn a recession into the Great Depression.

We do have an option here. We just have to hammer on our elected officials to take the other route. The current war on prosperity will produce more poverty and less freedom. De-leveraging does not have to end this way.